Valuing Asset Insurance in the Presence of Poverty Traps: A Dynamic Approach

Ample evidence exists to suggest that nonlinear asset dynamics can give rise to an environ­ ment of poverty traps. When dynamic asset thresholds matter, asset insurance offers great promise for managing risks that vulnerable households face. In this paper, we use dynamic programming techniques to generate an option value measure of welfare gains attributable to asset insurance in this context. In particular, we analyze how insurance influences dy­ namically optimal behavior near a critical asset threshold. Similar to other studies, we find that households with asset levels near a critical asset threshold will choose low levels of in­ surance due to a high shadow price of liquidity. However, unlike previous studies, we show that the very presence of a formal insurance market actually encourages greater investment by “threshold” households. This investment comes from the hope of reduced vulnerability that insurance offers in the future. Finally, we use our model to make predictions about the value of index-based livestock insurance (IBLI) in Marsabit district of northern Kenya. Our results suggest that these behavioral changes brought about by insurance may result in decreased poverty levels over time. Sarah Janzen is a Ph.D. candidate in the Department of Agricultural and Resource Economics at the University of California, Davis. Michael Carter is a Professor in the Department of Agricultural and Resource Economics at the University of California, Davis. Munenobu Ikegami is a post-doctoral scientist at the International Livestock Research Institute in Nairobi, Kenya. We thank the BASIS Research Program on Poverty, Inequality and Development and UKaid (Department for International Development) for financial support. We also thank seminar participants at the 7th International Microinsurance Conference and the I4 Technical Meeting 2011 for helpful comments. All errors are our own.